The good times roll

By BRENT SHEATHER


This year has begun as last year ended; the good times continue to roll.

In the first quarter of the year, an investor with a balanced portfolio - as used by the average pension fund - would have enjoyed a gain of 2.8 per cent before tax and fees.

The return for the 12 months to the end of March - 15.2 per cent - appears the best for some time, although, looking back over three years, most portfolios will still be underwater after fees and tax.

As the graph shows, each of the major investment classes made a positive contribution this quarter.

Highlights included the Japanese market, which stormed away, rising 14.4 per cent on confidence that deflation is a thing of the past and renewed hope that corporate Japan is now managed for shareholders ahead of anyone else.

The global listed property index rose 11 per cent in the three months as investors, particularly in the US and Europe, aggressively chased yield. That should please the NZ Superannuation Fund, which is putting some money into listed property.

In contrast, the New Zealand listed property index rose only 2 per cent in capital terms, though it now offers one of the developed world's highest yields on securitised property.

Paying dividends of around 8 per cent, and with sensible management in the main, New Zealand listed commercial property is one of the few sectors where total returns of 9 or 10 per cent a year still look achievable.

Among the largest stocks on the local market, returns in the quarter ranged as high as 38.9 per cent, for the NZ Exchange's own shares and 21.6 per cent for Fisher and Paykel Appliances. Over the year, F&P Appliances' shares are up by a phenomenal 112.9 per cent.

Within the major global sharemarkets, returns ranged from that high of 14.4 per cent in Japan, way down to 0.7 per cent in the US and 0.3 per cent in Europe. The Australian market returned 5.2 per cent.

However, it was possible to do considerably better than the average 2.1 per cent return on international shares by taking on more risk; global emerging markets rose by 9.4 per cent.

One year ago the world was bracing for the start of the Iraq war and international stockmarkets touched low points. However, as the war progressed quickly and economic and profitability indicators surged, international shares enjoyed a very strong run.

Over the year to the end of March, the MSCI index of global shares rose by 44.5 per cent in US dollars, and 21.1 per cent when converted into New Zealand currency.

Armed with these flattering statistics, fund managers will no doubt be busy preaching the virtues of global investment. But - while it appears to contradict common sense - this steep rise in prices now makes markets more risky and prospective returns lower.

Until early last month, it looked like another punishing quarter for global share investors operating in New Zealand dollars, thanks to the kiwi's continued rise against the US dollar.

However, the kiwi's flight ended with a bump; from its peak of 71USc in mid-February, it finished the quarter at 66.04 USc. If it had stayed at its peak, the return on international shares would have been negative 5.1 per cent rather than a 2.1 per cent gain.

This fall only brings the kiwi back to where it was in January and farmers are unlikely to be too impressed.

Whatever those who analyse currency graphs might say, a fundamental viewpoint is that New Zealand needs an exchange rate that will allow farmers to make a decent return on their investment. With farm prices still close to historic highs, the kiwi needs to fall a lot further before most farmers earn their 8 to 10 per cent cost of capital. Either that or farm values go down.

A British economist argued recently in the Financial Times that the only reason for the pound's strength was Britain's relatively high short-term interest rates.

Over there, three-month wholesale yields are 4.2 per cent versus 2 per cent in Europe, 1 per cent in the US and virtually nothing in Japan. In a 1 or 2 per cent world, New Zealand's 5 per cent short-term interest rates are a gift from heaven.

How much short-term capital would flee this country if our short-term rates fell to 4 per cent and what would be the impact on the currency markets?

With an economic slowdown in this country looking more likely, it is a brave investor who keeps all his or her money in short-term New Zealand dollar deposits.

Over the past 10 years, a "leave it in the bank" strategy has, perversely, outperformed more risky investments - international shares, global bonds, - and almost equalled the return from NZ bonds.

What's the bet that in the next decade cash returns will be back to where they should be in a rational world, at the bottom of the performance tables?

While it might not be obvious to New Zealand investors, the market in American treasuries - government bonds - delivered some very good returns in the quarter as medium-term interest rates fell sharply.

Ignoring currency movements, they returned 4.1 per cent for the quarter.

As recently as December 1999, you could earn 6.5 per cent from 10-year US Government bonds and the real yield, after inflation, has historically ranged from 1 per cent to 3 per cent.

Today's 3.9 yield does not leave much of a margin of safety for inflation, so it seems clear that bond investors are pessimistic and not expecting economic growth to accelerate any time soon.

Clear, that is, until you look at US sharemarket valuations, which reflect a very optimistic view of the long-term profit growth rate, rising at 6 to 8 per cent a year.

This is certainly way too high compared with historic earnings growth. It is even more ridiculous when 10-year bonds are yielding only 3.9 per cent.

During the 20th century the average long-term nominal growth rate for earnings was only slightly more than 4 per cent, and nearly 3 percentage points came from inflation. After inflation, in other words, real profit growth was about 1 per cent a year.

Against that background, it seems likely that either current bond yields are too low or share prices in the US are too high.

No less an authority than the mother of all stockpickers, Warren Buffet, apparently opts for the second scenario as he notes in the latest Berkshire Hathaway annual report that cash is his preferred asset class: "When we can't find anything exciting in which to invest, our default position is US treasuries. No matter how low the yields on these instruments go, we never reach for a little more income by dropping our credit standards or extending maturities."

A bit of good advice there too, perhaps, for the fans of local high-yield finance company debentures.

* Brent Sheather is a Whakatane investment adviser